Notional Amount

The notional amount, also called notional principal or notional value, is the reference size of a derivative contract: the face amount used to calculate the payments the parties owe each other. In many derivatives, such as an interest rate swap, the notional amount itself is never paid by either side. It is a yardstick, not a sum of money that changes hands.

Because the notional amount is usually much larger than the value actually at stake, it is a measure of the scale of a derivative position rather than of its risk. A swap with a notional amount of 100 million might have a market value of only a few hundred thousand, or zero when it is first agreed.

Different derivatives use the notional amount in different ways:

• Interest rate swaps. One party pays a fixed rate and the other a floating rate, such as SOFR, both calculated on the same notional amount. Only the net difference is paid on each date; the notional is not exchanged.
• Cross-currency swaps. In currency swaps, the notional amounts in two currencies are usually exchanged at the start and returned at maturity, so the notional does move.
• Forwards and FX swaps. In a deliverable forward contract or FX swap, the notional amount is the quantity of currency actually delivered on settlement.
• Futures. A futures contract has a standard contract size; its notional value is the contract size multiplied by the current price.
• Options. In an options contract, the notional amount is the quantity of the underlying asset multiplied by the strike or market price, while the buyer's maximum loss is only the premium paid.
• Credit default swaps. In a credit default swap, the notional is the amount of debt protected, which the protection seller may have to pay out, less recovery, after a credit event.

Two banks enter a five-year interest rate swap with a notional amount of 100 million. Bank A pays a fixed 4.00 percent and Bank B pays SOFR. If, for one annual period, SOFR averages 3.50 percent, Bank A owes 4 million and Bank B owes 3.5 million, ignoring day-count conventions. Under payment netting, Bank A simply pays Bank B 500,000, the 50 basis point difference applied to the notional amount. Neither bank ever pays the 100 million.

The risk in a derivative depends on how its market value changes, not on its notional size. Measures used to capture risk include the current market (replacement) value, potential future exposure, and value at risk. The Bank for International Settlements publishes semiannual statistics on over-the-counter derivatives showing that total notional amounts outstanding run into the hundreds of trillions of US dollars, while gross market values are a small fraction of that and net credit exposures after netting and collateral are smaller still.

Headline notional figures can therefore exaggerate risk, and the gap between notional and exposure grows when offsetting trades are left open rather than terminated. Trade compression services, which tear up redundant offsetting positions, reduce notional amounts without changing net risk.

Although notional amounts are a poor measure of risk on their own, regulators use them as inputs. Derivatives reporting rules require notional values for each trade. Bank capital frameworks under the Basel Committee standards use notional amounts, adjusted by supervisory factors, to estimate counterparty exposure and include derivative exposures in the leverage ratio, which affects regulatory capital. Thresholds for mandatory clearing through a central counterparty and for exchanging initial margin are also set by reference to aggregate notional amounts. When a position moves against a party, the resulting collateral demand, or margin call, is driven by changes in market value rather than by the notional size.